On February 24th 2022, the world watched in horror as Russia launched a full-scale military invasion of Ukraine. Over the next two weeks, the European Union Carbon Allowance (the “EUA”), the most liquid carbon credit market in the world, lost more than a third of its value. The California Carbon Allowance (the “CCA”), the second largest carbon credit market globally and the biggest in North America, posted a 14% loss during the same period.
It is worth noting that the EUA and CCA bounced back by 31% and 12% respectively over the three-day period between March 8th and March 10th. While short-term volatility remains extreme reflecting the threat that Russian’s invasion of Ukraine represents to the global economy, we reiterate our view, however, that carbon pricing remains significantly below levels necessary to incentivize the meaningful changes required to achieve climate goals, and that the long-term fundamentals for the carbon credit market remain very bullish overall.
Figure 1: Cumulative Returns (Feb 16 - Mar 10)
Global Carbon Markets
The energy & carbon correlation
Traditionally, carbon credits are mildly positively correlated with fossil fuel prices and commodities. The logic is that increased gas prices encourage companies to switch to high carbon emitting fuels such as coal and, as a result, increase demand for carbon credits. Since Russia’s invasion, the world stands on the cusp of an energy supply crisis. Despite the record high fossil fuel prices, the cost to emit carbon has seen a significant pullback. What happened?
Figure 2: Traditionally, carbon credits are weakly positively correlated with crude oil and commodities
Russia upsets the applecart
There are several possible reasons for the recent price decline: investors seeking liquidity in volatile market environments like the one what we are currently in, international investors could be offloading European assets, there are reports that some market participants may have been forced to sell EUA to avoid margin calls caused by losses from soaring energy prices, certain countries (such as Poland) are calling for a reform of the EUA system and stop losses could be triggered as a result of all the above. Although selling pressure has been significant, the recent price movement further reinforced the fact that carbon credit futures can increasingly be considered a liquid asset class.
On the fundamental side, early spring has traditionally been a weak season for carbon credits as winter-driven heating and power generation fade. In addition, there are fears that the invasion could cause certain industries to reduce economic activity, leading to lower demand for carbon credits.
Figure 3: Monthly EUA Return Performance 2017 - 2021
Are financial market participants truly to blame?
Financial market participants are increasingly blamed for the volatility in the carbon credit price. However, according to Carbon Pulse, which quoted a report by European Securities and Markets Authority (ESMA), the EU's securities market regulator - “speculative” activity only accounts for around 4% of activity in the EU ETS market. According to the Carbon Pulse analysis, "A high carbon price, combined with reduced volatility and more predictability and transparency, is fundamental to drive industrial decarbonisation. Ideally, carbon prices should rise steadily, without sudden spikes. But blaming financial speculation, the ETS, and climate policy for spiralling energy bills is disingenuous and unhelpful. If anything, high energy prices reflect a historic failure to decarbonise rapidly enough, leaving us dependent on volatile fossil fuel supplies...It is of utmost importance that the EU sets a high standard with its revision of the ETS, for a stable carbon market that encourages and enables industry to rapidly decarbonise, and that prepares the continent for the climate challenges ahead.1"
We believe that financial market participation is essential to drive the true price discovery of the carbon market. Ultimately, a stronger, more liquid carbon price incentivizes businesses to discover more sustainable business models and encourages everyone to be part of the energy transition solution.
No change to the fundamentals
Within the EU, the possibility of the EU pausing the emissions trading system in order to address near term growth risks caused by the war has become a discussion point. Amid EU’s dependence of Russian fossil fuels, Ursula von der Leyen, the President of the European Commission, reinforced the importance of EU Green Deal in her Twitter post on March 8th - an important component of the EU Green Deal is the strengthening of the existing emissions trading system. As the region focuses on energy security, a delay in the talks to strengthen the emission trading system is possible, but a cancellation is unlikely.
Figure 4: Twitter quote from Ursula von der Leyen on March 8
Furthermore, April 30, 2022 is the EU compliance deadline for surrendering sufficient carbon allowances against 2021 verified emissions. At the current lower carbon price, we see compliance buyers taking advantage to manage their compliance needs.
In North America, the long-term fundamentals remain strong. We continue to believe that an orderly energy transition, one supported by incentives like cap-and-trade programs, will sustain Canada’s position as an energy superpower and leader in the clean energy transition. The investment community has an increasingly fundamental role in helping to achieve net-zero goals.
Why Ninepoint Carbon Credit ETF?
For an emerging asset class like carbon credit, volatility management is at the heart of our fund strategy. At the moment, the Ninepoint Carbon Credit ETF invests equally in the three major ETS markets globally with quarterly rebalancing. This strategy has demonstrated remarkable resilience in the unprecedented carbon market volatility.
Figure 5: Performance of Major Carbon Markets (Feb 16 - Mar 10)
Reasons for investors to consider Ninepoint Carbon Credit ETF:
1Carbon Pulse, COMMENT: Higher carbon prices – is speculation truly to blame?
1All returns and fund details are a) based on Series F $USD units; b) net of fees; c) annualized if period is greater than one year; d) as at March 14, 2022.
2Sector allocation as at March 14, 2022. Sector allocation based on % of net asset value. Numbers may not add up due to rounding. Cash and cash equivalents include non-portfolio assets and/or liabilities.
The Ninepoint Carbon Credit ETF is generally exposed to the following risks See the prospectus of the Fund for a description of these risks Absence of an active market for ETF Series risk, cap and trade risk, collateral risk, commodity risk, concentration risk, cybersecurity risk, derivatives risk, foreign currency risk, foreign investment risk, Halted trading of ETF Series risk, inflation risk, interest rate risk, liquidity risk, market risk, regulatory risk, securities lending, repurchase and reverse repurchase transactions risk, series risk, substantial securityholder risk, tax risk, trading price of etf series risk.
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